Firms often offer equity shares to their senior managers, a form of compensation traditionally viewed as incentive pay that spurs managers not only to work hard to maximize the value of their firm but also to take the entrepreneurial risks that shareholders prefer.
A common form of equity compensation is to provide options — that is, the opportunity to buy shares at a set price, or strike price, which can be exercised at any time — rather than to provide shares themselves. For example, a manager with the option to buy a security at $100 per share need only wait for the option to be in the money — that is, for the market price to exceed the $100 strike price. The manager can buy at the strike price, then immediately sell the security at the higher market price. Conventional wisdom holds that this compensation may incentivize managers to take more risk.
To see why, suppose that a manager has the option to buy shares in her firm at $100 per share and that the market price of those shares is currently $50. If the firm continues more or less as it has been, the manager’s options are likely to expire out of the money, because the share price will not be above the strike price of $100. However, if the manager takes some big risks, there is at least a chance that those risks will pay off, the firm’s share price will rise above $100, and the manager will make money on her options. Option-based compensation packages are thus said to encourage risk-seeking behavior, which, to some degree is what shareholders want — but when carried to excess can lead to poor outcomes. Risk-seeking behavior is also the opposite of what lenders want, since they value safety above all else.
However, according to Professor David Ross, the conventional wisdom ignores the fact that managers frequently do not exercise their options, even after those options are in the money and have vested, that is, may be exercised at a manager’s discretion.
Why would a manager forgo cashing in valuable options? “It’s an accepted idea that managers, based on the inside information they have about the firm, may hold to their options if they believe that their firms are likely to continue to do well,” Ross says, “but what does ‘doing well’ in this context really mean? Given that the options are already in the money, the managers might believe that the firm’s fortunes are unlikely to change much one way or another and thus that there is little chance the options will drop out of the money; that would be great news for lenders, who value safety, and would suggest that the risk-seeking behavior attributed to options actually becomes risk-averse behavior once those options vest.” If so, the signal generated by a manager holding on to options after they vest would be particularly valuable to a lender.
Ross and Cristian Dezsö of the University of Maryland tested this hypothesis by comparing companies with themselves over time. In particular, they assessed how a company’s borrowing costs in the loan market tended to go up and down as the value of its managers’ holdings of vested options increased and decreased over time, while controlling for changes in share price performance.
The researchers found that when the top five managers’ average holdings of vested options are relatively high, the company’s borrowing costs are relatively low. Further, when the researchers looked at the volatility of share price — a key indicator of risk — they found that it tends to decrease when managers retain large portions of their vested options. “Low share-volatility implies a firm in a stable situation, precisely what lenders like to see,” Ross notes.
A key takeaway from the paper, Ross says, is that it’s not necessarily the case that the more leveraged the executive compensation contract is, the more risk-seeking the manager will be. “That’s because most people are risk averse by nature,” he notes. “The average person — and the average manager — who is risk averse and who has a set of options that are just barely in the money is going to try really hard to keep those from going out of the money.”
Ross suggests that the results should prompt firms, boards, and investors to reconsider the design of executive compensation programs. “If a manager remains on a senior executive team for years and the board keeps offering her contracts with options that vest, she will wind up with a fairly significant investment in the firm over which she will have a lot of control,” he says.
“There’s often the feeling that executive compensation programs are rigged in favor of senior managers and lack real incentives for managers to work smarter,” Ross says. “While there have been some egregious examples of that in practice, and our paper doesn’t study that question directly, it does provide evidence that just because senior managers have equity doesn’t mean their interests are aligned with equity. In fact, it suggests their interests may be aligned with debt.”
David Ross is assistant professor of management at Columbia Business School.